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SEBASTIAN MALLABY: Okay. I think we can get started. For those of you who don't know me, I am Sebastian Mallaby. I direct the Maurice R. Greenberg Center for Geoeconomic Studies here at the council. Thanks for coming to this latest meeting in the World Economic Update series.

Familiar housekeeping points first. This meeting is on the record. And please turn off those cell phones, things that go beep, vibrate, mess up the sound system, et cetera.

We've got two terrific speakers to get us up to date on what's going on. To my immediate left, Jacob Frenkel, chairman of JPMorgan Chase International, a long list of distinguished appointments before that. But I'll just pick out, two terms as governor of the Bank of Israel in the 1990s. Before that, sort of the chief economist role at the International Monetary Fund. And before that, on the economic faculty at Chicago.

And then over there is Steve Roach, non-executive chairman of Morgan Stanley -- (laughter) -- sorry, I'll be more precise in my language, in my gesticulations. So Steve Roach is chairman with Morgan Stanley international. Before spending, I guess, three years in Asia from 2007 to 2010, he was a longtime chief economist at the respected, kind of global (macroteam ?) at Morgan Stanley, and before that, a senior economist at the Federal Reserve Board in Washington.

So here we are. We want to update the world, at least its economy. It's not looking good. If you just look at the OECD forecasts, I think it adds, because it's a recent one, they have annualized growth in the third quarter that we're now in roughly at about half the rate that it was over the last quarter.

I was on a panel last night with Nouriel Roubini. You will not be surprised to hear that he thinks that the OECD forecast is way too optimistic. He thinks that, for example, the projected 2 percent in this quarter should be more in fact under 1 percent somewhere.

So Steve, let's not beat around the bush here. (Laughter.) Let's get to the obvious question. What the heck is going on? What -- (inaudible)?

STEPHEN S. ROACH: Did you say bush? (Laughter.)

MALLABY: I think that's your paranoia, not my linguistics. (Laughs.) Yeah, I think -- and so the question is, do we need more stimulus? I mean, monetary, fiscal, what mix? Or don't we need it?

ROACH: Well, Sebastian, the world is in trouble because the biggest economy in the world, the U.S., is dealing with the aftershocks of an era of extraordinary, reckless excess. And the biggest sector in the U.S. economy is the consumer. And the consumption share of U.S. GDP, close to 71 percent. It's still five points above the norm that prevailed in the final quarter of the 20th century when consumers were more rational, they spent out of income rather than borrowing against asset bubbles to draw down their savings rates to zero and take their debt loads up to records.

So we're in a period where that process is going to unwind now. And the consumption share of U.S. GDP is going to mean over the next several years, which means, you know, a percentage point reduction in the consumption share of U.S. GDP.

And stimulus, you know, if you do a classic Keynesian stimulus, you know, along the lines of the one that was enacted last year, it's not going to reverse that process. So I think we need to be wiser, prudent and more targeted in the way in which we try to provide stimulus, providing relief to the innocent victims of this recession, sluggish recovery and high unemployment.

We need targeted assistance to the long-term unemployed. We need a lot of retraining and re-skilling.

And then we need to focus on directing incentives for the types of activities that have always made America great. You know, on that basis, I applaud the initiative of the Obama administration to make the R&D tax credit permanent. But we need a lot more to stimulate the innovation in new technologies and new concepts.

And we just -- you know, believe me, I'm not a Tea Party person, but I can certainly understand the anger of a broad cross-section of Americans who just want to throw the rascals out, because they come up with the same, you know, tired, empty, vacuous rhetoric that got us into this mess in the first place.

So I think we have to be smart in the way we provide stimulus and not dogmatic, not idealogical. And you know, I think the role for monetary policy is very, very limited, despite what "Helicopter Ben" tells us.

And Jacob, of course, has done an awful lot of work on that over in his career, and probably has something to say on that as well.

MALLABY: Yeah, Jacob, I mean, I think it's right to say that in the late '80s at the International Monetary Fund, you were already talking about and analyzing the question of overburdened monetary policy. Are we back in the same world now where we're just asking too much of the central bank. And you ran one for 10 years. What's your view on that?

JACOB A. FRENKEL: Well, the answer is yes, but let me moderate it by following up on what Steve said. I felt to fully agree with you, but it has been a curse of us for the past few years that we agreed too much.

On the issue of stimulus, we need to find out why the stimulus package was less effective than what was hoped for. And unless we do that, doing more of the same is probably the wrong direction.

We had here yesterday a discussion in the morning, some of you may have heard it, speaking about the upset that a large deficit has on capital spending by corporations. So if you think that the estimate that we got yesterday was about 30 percent or 50 percent, that if you increase government budget deficit, that in and of itself will have an upset on the inclination of corporations to invest.

And one of the reasons is -- and that's part of the first answer -- when you see a large stimulus budget with a deficit and you don't see how you get out of it, obviously you are going to sit on your hands until the sun clears. So that's point number one.

It does not mean that there is no role for government. On the contrary, there is a significant role. But the role of government is not to compete with the private sector, but rather to facilitate the private sector. So we need to have a much longer-term perspective.

And most importantly, we need to understand how the sovereign debt crisis that has emerged all over the world is not going to plague us.

As far as overburdening monetary policy, there is an illusion that monetary policy, because it is a flexible policy instrument, and because it does not require Congress for an action, that's a good policy instrument to do Mickey Mouse policy up and down.

The reality is -- and I don't, by the way, refer to the current policy as Mickey Mouse. I'm talking about the inclinations of saying, well, here there is the policy instrument. You can do it, just get your act together. Sit down in a room, raise your hands, get a majority and move on. You don't need Congress.

And before long, you'll find that you have basically given a license to the true policy instrument that has to be implemented, the fiscal policy. You gave it a license to stay dormant, because some of the (others ?) will take the burden.

Let me make one more analogy, an analytical one and some material for thought. When you are a conductor of an orchestra and every musical instrument plays exactly according to the music that it has to play, you have harmony. And that's what people pay for.

Now, suppose now that one of the important policy instruments is playing off tune. As a conductor, what should you do? Your first inclination is to bang on him and say, why won't you get back to the harmony while the rest of us musical instruments play the right music? But if you give up and you basically say, okay, I know that you cannot do that, or you tell me that you cannot do that, what would you do as a conductor? Would you continue with a cacophony where the rest of the policy instruments do allegedly what they were supposed to do, but it doesn't match what he is doing, the major instrument? Or would you change now the music that the others will need to play so as to bring to a distorted harmony consistent with the off-tune playing of the major instrument?

It's a major question. Because in the short run, the inclination is to say, well, save the day, the other guy is not playing, jump into the vacuum. And this was the logic of the ECD, jumping when the fiscal authorities did not do things. This is the logic in this country where monetary policy is doing much more.

And I'm not saying that it should not be done in the short run. But there is always the tendency that you get into bad habits. We have here the tradition that monetary policymakers do not discuss publicly the fiscal policy standing. But we all know that's the true gorilla in the room. And without the fiscal policy discussion, putting up front a strategy for exit, we are playing the wrong game by discussing again and again the policy instruments that are practically exhausted.

MALLABY: But if we take sort of concretely, what is the danger? Excess monetary policy, excess stimulus from the monetary side, is the problem that it's sort of potentially pumping up demand, getting us back to somewhere nearer to what the economy's growth potential is, but at the cost of distorting the structure of the economy, because the interest-rate-sensitive chunks will grow first, you will get more boom in real estate and again?

ROACH: No, Sebastian. I mean, this is the same argument that we had after the bursting of the equity bubble in 2001 and 2002, although it's amplified because the degree of the stress is so much more acute.

And in the aftermath of that earlier post-bubble period, we had a central bank that embraced a period of extended, excessive monetary accommodation and stayed easy for far too long, despite the protests of the former chairman of the institution, who was, I believe, sitting on this stage yesterday, and his successor, both of whom strenuously argue that monetary policy had nothing to do or very little to do, they might concede in their darkest moments, with the subsequent bubbles that occurred in property and credit.

I personally think that's ludicrous. And by going back to the same script that recreated the monster bubbles, we have a central bank that is ignoring the role of liquidity and leverage and asset bubbles, and distorting the real side of the U.S. economy. And I don't think that we should condone that type of behavior again.

I'm jumping ahead, but I think -- and I know you want to get to the, you know, the Frank-Dodd regulatory initiative as well as Basel III. But you know, I think the regulatory fix is necessary, but not sufficient to avoid these problems in the future. If you don't address the serious flaws of monetary policy, we're going to have this mess again. You're entirely right.

FRENKEL: Well, the issue of bubbles has been with us for many, many years. And there was always the question of, should monetary policy burst the bubble before the bubble bursts?

And the general debate has been on the question of, does the monetary authority have an informational advantage that the private sector does not have? And if yes, then it should act upon it. If not, then it's a different matter.

In the old days, the objective of monetary policy was price stability. As we move on, the objective now all over the world is price stability and financial stability. And of course, bubbles that (are ?) -- go out of control do impact significantly financial stability, because when they burst, they upset balance sheets of everyone, including financial institutions, and create a lot of further pro-cyclical developments that are not desirable.

However, we need to draw a distinction between two types of bubbles. Bubbles that arise from debt finance or bank finance growth, if they arise from that, then to mop up the mess in the aftermath is rather complicated. And when it comes to bank finance and debt finance, the central bank may have actually an informational advantage.

On the other hand, bubbles of the type of, say, the dot-com that reflected more equity finance, well, there is no presumption that the central bank has an informational advantage or therefore that it should really be actively playing around with it.

So the issue is more subtle than what --

MALLABY: So in other words, your view is that the Fed, after the dot-com, sort of learned a generalized lesson about how to treat bubbles by cleaning up afterwards. And you're saying, no, there's two different kinds of bubbles. If it's a bank-fueled, credit-fueled bubble, that's different.

FRENKEL: Because the logic is not whether bubbles are good or bad, but rather, does the monetary authority have the information and advantage?

There is one important distinction between monetary policy in general and fiscal policy. Monetary policy is an aggregated policy. It affects the aggregate of the economy. Of course, some sectors are more sensitive to interest rates than others. But when you have a monetary policy, it affects everything.

Fiscal policy is designed to be a sector of policy. So there is a sectoral issue. That's why you have tax instruments and the like. And we should really not confuse between the two.

ROACH: But let me just go back to a point you made earlier, Jacob, where you said that, you know, in the old days, it was price stability, and now it's price stability and financial stability.

You and I are both old enough to remember before the old day.

FRENKEL: Older day. (Laughs.)

ROACH: In 1946, the Employment Act was passed by the U.S. Congress that mandated the central bank solely to focus on full employment, legacy of the Great Depression. It worked great for 30 years, then the Fed blew it, double-digit inflation. Humphrey-Hawkins legislation passed in 1978, which then added price stability to the explicit mandate. I would argue that the Fed has blown it again.

So you say that, well, everybody now focuses on financial stability. I don't trust the central banks to say, oh, don't worry, we've learned our lesson. I want that hardwired into the mandate. I want the Fed and other major central banks to issue a financial stability report every, you know, six months or 12 months. I want them to set not just the federal funds rate, but other types of policy instruments, whether there are margin requirements on equities or down payments on property, like the Chinese are doing right now, to utilize the full range of their authority to prevent these bubbles from infecting the economy.

And finally, I would just say, you're entirely right in saying that monetary policy is a blunt instrument. We needed a blunt instrument to deal with these problems.

At their worst in the 2005 to 2007 period, the bubbles in property and credit distorted consumption and home-building activity, which were collectively 77 percent of the U.S. GDP. That's what you have a blunt instrument for. The whole economy was distorted --

MALLABY: But I think Jacob is agreeing with that, right? And he's saying --

ROACH: Yeah.

MALLABY: -- when you have a credit bubble like that, you should act.

FRENKEL: But his voice is intending to create an atmosphere for debate. (Laughter.)

ROACH: Yeah!

MALLABY: Let me put something else on the table.

ROACH: It's my genetic predisposition.

MALLABY: Let me put something else on the table, which we've been talking about, but, Jacob, I want to put this a bit more directly.

So we've been talking about the way there is potentially a trade-off between short-term return to growth and whether it's long-term sustainable. And in some ways, stimulating too much now could make it less sustainable, right?

But there is one dimension on which early stimulus could actually raise the longer-term trend potential, and that is through the labor market. I mean, if you let people stay out of work for an extended period, we all know they de-skill, they drop out of the labor force, and, effectively, you've lost productive labor, you've lost skilled labor. So that's an argument, isn't it?

In other words, if you just take the whole picture in terms of this long-term/short-term trade-off, some of these arguments point in the direction that long term gets you more short-term growth -- I mean, short term gets you more long term, and others don't.

So where do you come out on that?

FRENKEL: Well, two points. First, you are perfectly right that when you ask, what's the rate of unemployment in an economy, that's not good enough of a statistic. You need to ask, what's the unemployment rate of the economy? And what's the average length of the unemployed cohort in the unemployment group?

Because we all know, and that's universally established, that the longer one is unemployed, the more likely it is that he will not regain employment. He may actually leave the labor force. So the length of time is important.

And in this regard, we should not allow things to get out of hand, so to speak.

But the solution for long-term issues, the solution does not come from shorter measures. If you ask, what's the unemployment rate among well-educated, high-skilled individuals? There, the unemployment rate is very, very low. It so happens that most of those who have been employed in the consumption industry are also low-skilled individuals or lower education.

So the long-term solution is an educational system and retraining system and the like. And then you come and say, yes, but how will I make it to the long run? I need to survive. Let's do some short-run policies. And that's where your question is so pertinent.

I don't -- I'm not -- I'm not too excited from the sharp distinction between short term and long term. If you don't do the right long-term policies, your short-term measures will be less effective than what they would have been if it was in an environment in which there are long-term sustainable policies.

The essence of capital markets is exactly designed to blur the distinguishing between long run and short run, because if you all expect something to happen in the long run, the beauty of capital markets is that it brings it back to the future.

The nonsustainability of short-term measures that can be measured only by the long-run consequences immediately impact adversely on the effectiveness in the short term.

So I would not really have a department dealing with, you do the short run and the other one does the long run. In the old days, there was such a distinction. For example, the IMF was supposed to deal with short run, the World Bank, long run. It just does not work. There is no way to go to the one without having the right policy on the other.

MALLABY: Steve, a question on China. You know, this week, I think today, actually, Tim Geithner is in Congress testifying about what he thinks on the Chinese exchange rate. It is a bit of a mystery, isn't it, that they announced, the Chinese, an apparent policy shift on the exchange rate, and then basically didn't deliver. And in the meantime, they have succeeded in annoying not only the U.S. Congress, which is a pretty low threshold -- (laughter) -- but they've got the Japanese intervening in their currency markets in response, and now the Europeans are angry that the Japanese have done it unilaterally.

They've potentially set up a sort of chain reaction here. Why not just move a little bit?

ROACH: Well, first of all, Sebastian, when the Chinese announced that their sort of temporary crisis-driven suspension of their managed float was over last July, they didn't lay out a trajectory of the renminbi cross rate. They simply said that, you know, we're going back to a more flexible policy.

And they have a policy that gives them the leeway to vary the renminbi And they have elected in a still extremely fragile global climate to be very cautious and judicious in the way in which they let their currency fluctuate. You know, the political protagonists of course refer to this manipulation. And the Chinese and others, including myself, refer to this as a focus on a stability anchor for an embryonic financial system.

And given what's gone on in world financial markets in recent years, having a stability anchor and policies that are aimed at that is not a particularly bad thing.

But obviously, this is a political year. And Tim Geithner is, I think, very mindful of not just the politics, but the complexities of dealing with bilateral cross rates in a multilateral world. And he actually, I think, did a fairly effective job in addressing that issue last spring and was hopeful that the Chinese would give him some cover.

That has not turned out to be the case. And now with the election season at hand and the drumbeat in the Congress getting louder and the Obama administration, and the Democratic Party in general, in serious trouble, then the rhetoric gets dominated more by politics than by a global macro.

But you know, the point to make in the United States is another dimension of this very painful reality. And that is that if we think for a moment we're going to solve our problems by bashing the Chinese, we are diluting ourselves.

Our main problem is the lack of national savings, an overall national savings rate adjusted for depreciation that is now negative to the tune of, you know, minus 2.5 percent of GDP. So we need to import surplus savings from abroad in order to grow, and then we have to run these massive current account and multilateral trade deficits to attract the capital.

Last year, we ran bilateral trade deficits with 90 -- that's nine, zero -- countries, including the Chinese. So if we pass a currency bill and don't save, which we're not going to do, and say, shut down the Chinese, the Chinese piece of our multilateral imbalance goes somewhere else to a higher-cost producer which taxes the American public.

But you know, the Congress is clueless in understanding this. I've testified repeatedly on this subject. And I gave up and moved to Asia. (Laughter.)

MALLABY: I want to bring in the audience in a second. But Jacob, maybe you could just comment briefly on Europe. You know, we've had a trillion-dollar bailout for Greece, roughly, and spreads seem to be back up to almost where they were. Why do the markets remain so skeptical about --

FRENKEL: Well, to begin with, it used to be called the problem of Greece. With the passage of time, it became clear that Greece is not the name of a country, it's the name of a phenomenon, a phenomenon that is shared by other countries -- Ireland, Portugal and the like.

And the phenomenon is a phenomenon of significant sovereign without a mechanism that convinces the market that that sovereign debt can be paid in the right way.

And indeed, if you ask yourself, what happened during the decade or so, a little more, since the introduction of the euro, there was no issue of imbalances or things of that type within Europe at that stage. And then a decade passed. And how did the various countries respond? Greece, Ireland, Portugal decided to give a party and to increase their consumption and spending to an extraordinary degree, cut down their savings by about 12 percentage points, or 14, depending on which country.

And of course, if you do it, you have to borrow and incur debt. And in Greek situation, the debt was foreign debt.

On the other side of the very same euro, you had Germany which decided to raise its savings rate. So lo and behold, Germany has been running surpluses in the current account; the rest of the eurozone countries, the problem countries, big deficits.

So this party had to get to an end. When the rest of the world, namely the Europeans, had decided to put on the line commitments of up to $1 trillion, everyone, the ECB, the European community, IMF, the idea was, we will put enough money so as to convince the market that in the coming two, three years, even if all of these countries did not have access to the capital market, they have enough resources to service the debt. And therefore, you, capital market guys, don't worry, there can be no default, there is enough money.

Where was the skepticism? The skepticism comes from two dimensions. Dimension number one is the short term, because everything was dependent upon a very significant structure adjustment in many of these countries that have lost competitiveness. And the question that markets had was, will the political process sustain such a dramatic change? And if not, then it doesn't help that there is enough money there, because the money is conditional on policy.

But the second and most fundamental one is the question of, what will happen after two, three years when there is no additional aid? Will these countries create the infrastructure that will sustain growth without external help so that they can go to the capital markets? And here there are significant doubts.

Same question that we had on the first issue of the stimulus in this country. We now see that, as the effect of the various stimulus measures are withdrawn, the question has been, will there be enough momentum? Or are we going to do need to do something else?

So that's the reason why the markets are very, very nervous. And it is again the issue of capital markets. The capital markets do not tolerate the distinctions between long run and short run. They will show you in the short run (or in the middle ?) exactly what they believe will happen in the long run. And it doesn't help that you have something for the next two years.

ROACH: But Jacob, just to follow up on that, I mean, aren't you surprised at how low long-term sovereign bond yields are in the context of what you just said?

FRENKEL: Well, the reality is that Greece has now spreads over Germany of about, how much? Nine hundred basis points?

ROACH: Yeah, the spreads are wide. But what about, you know, the benchmarks --

FRENKEL: The level itself.

ROACH: -- (less free ?) in the levels.

FRENKEL: Yes, that's correct. Yeah. Our paradigm is challenged here. We all would have thought that by now long-term interest rates will be higher than what they are. And potentially, even inflationary pressures would have been higher than what they are.

But I would not give a party today. (Laughter.)

MALLABY: Okay. Well, with that, let's have a party here. And who's got questions from the members in the audience?

Let's go right here to begin with. Please state your name and affiliation.

QUESTIONER: Niso Abuaf, Pace University. I would like to hear the panel's thoughts on the deflation versus inflation debate. And associated, why the rewrites of interest in the TIPS market are so low. Thanks.

MALLABY: That's a good segue from where we were before.

ROACH: Well, I think over the reasonably foreseeable future, the risks still are skewed more toward deflation than inflation. There's just enormous slack in the global economy. I don't look for a sharp precipitous deflation. It would be more of a, you know, a periodic dip from time to time, depending upon the state of the global economy.

I think the inflation issues are fairly distant. And I think the bond market is generally consistent with that. They will arise if, at some point in time, it looks like it's evident that we're starting to absorb the slack capacity in the global economy and we don't have credible exit strategies for the fiscal and monetary authorities.

And then I think there is a legitimate case to be worried about that. What the authorities are telling you is, you know, trust us, we know what we're doing, and we have time to develop coherent exit strategies.

The history of the last 20 years suggests that one should be rather dubious of trusting our wise public authorities in that regard.

FRENKEL: Well, I'll make two points about it. First, you spoke about the last 20 years. I want to take you to the last 80, 90 years. When you are looking around the world and ask, why is it the case that in Germany there is greater concern about inflation than in some other places in the world, the answer is their legacy from the hyperinflation of the '20s. Practically, there are very few individuals that are alive that have actually experienced that one, but it is becoming part of the DNA.

When in the U.S., some years ago, there was the popular view that our main danger today is deflation, I can tell you that in some countries of the world, especially in Latin America -- and I can tell you also, where I came from, from Israel -- there were some eyebrows raised by saying, well, you are spoiled, you did not experience the inflation as these countries have, and therefore don't be excessively sanguine about it. It does not mean that you need to be (paranoic ?) about inflation. And I agree with Steve's assessment that today there are really basically no inflationary pressures anywhere in the pipeline. That's not the issue.

The issue is, as a strategy, do you want to design a policy which is asymmetric, namely be more nervous from the deflation than from the inflation as a central bank, not as a conductor of the orchestra? Or do you want it to be symmetric?

In Europe, it is symmetric. In most countries of the world, it is symmetric because of the legacy. In this country, it is now somewhat designed to be asymmetric. And that's an open issue, especially when one recognizes that markets do not always recognize political boulders.

So what is true in one part of the world and is not always true in another part of the world needs to be reconciled.

MALLABY: Okay, let's go over here. Wait for the microphone.

QUESTIONER: (Off mike.)

MALLABY: Microphone.

QUESTIONER: Excuse me. Steve Robert. Both Chairman Greenspan, who was here yesterday, and both of you, I think, are warning us of the dangers of the government deficit and particularly as it relates to a chewing up of savings and lack of capital investment by the corporate sector.

So that seems to go in the direction of removing stimulus faster and solving the deficit problem faster. That's certainly what Chairman Greenspan said yesterday.

On the other hand, there's a whole other group of economists who have the opposite view. And they tend to cite very often 1937 where the government tried to retract stimulus and come closer to balancing the budget. And the general feeling is that exacerbated the depressionary environment we were in.

And then they come to something more recent, which is the Japanese experience over the last 15 years. And it appears that each time they move toward fiscal restraint, their slow economy or recession got worse and worse.

So are we in a period more like 1937 or Japan in the last 15 years, where it might be very dangerous to try to deal with the deficit too fast?

FRENKEL: I think that this is probably the most central issue today in the policy arena. And in order to respond to it properly, since both considerations are correct, if you withdraw it now, you aggravate a recession, if you accelerate it now, you aggravate the debt problem. And you need to basically be a bit more refined, and the refinement has to do with two dimensions. First, the composition; and second, the timing.

Composition -- one of the reasons why, as Steve said at the very beginning, a part of the stimulus package was less stimulating than what it was intended to be, was that it did not really enhance sufficiently the infrastructure that would promote growth once it is withdrawn. Spending were in the directions, at the end of the day, were more improving the standard of living of some very important segments and things of that type rather than focusing specifically on, what will maximize growth prospects once it is withdrawn? So the composition is an area.

Unfortunately, the location of government budgets are determined, among others, by political considerations. And the things that are enhancing growth do not have a strong political logic because the beneficiary is not identified immediately in the same moment.

The second point has to do with the timing. We should not ask only, what do we do in 2010 and 2011, because this really is too constraining. I repeat what I said before. The same stimulus budget that will take place in 211, along with a very explicit discussion and presentation about what will happen in 213, '14 and what's the mechanism to close the deal, will be very much more effective than if it is an open-ended one.

Because time and again, when you talk to the corporate sector, they will tell you, I am reluctant to move because of the uncertainty that I am there. The government need not add to the uncertainty, but rather to reduce it. And that's really one of the important points.

ROACH: I agree, this is a critical issue. And thank you for raising it. There's a lot of fear mongering going on ala hearkening back to the mistakes that were made in 1937. And out of that fear mongering comes the belief that you shouldn't dare discuss the restoration of normal fiscal or monetary policies in this environment.

And I think that that's really ideologically far too extreme for me. I'm not arguing that we should move aggressively to fiscal or monetary normalcy to date, but we do need to have, as Jacob just said, a reasoned discussion about how we are going to find a way out when, you know, we're through the worst of the situation.

And I think it's very important for us, if we're considering additional stimulus actions to deal with the victims of long-term unemployment or to put in place incentives for research, development and innovation, that any additional stimulus must be accompanied by a much more explicit definition of what an exit strategy will look like.

It is reckless to just go to the American people and say, you know, here's another few hundred billion and, you know, we'll deal with it later. The reason we won't deal with it later, because if I'm right, and the second part of your question plays to something I'm very sympathetic to, is that we are in a slow-growth Japanese-like scenario that will not generate enough growth to produce the normal windfall of revenues that will self-correct the budget deficits that we've built today.

We're going to be stuck with a legacy of federal debt, as the Japanese are right now with their debt-to-GDP ratio of 200 percent.

MALLABY: Great, but if --

ROACH: Let me just say one last thing, because I do want to find one point to disagree with Jacob on -- (laughter) -- and that is, this ridiculous notion -- and this is not -- and Jacob is borrowing it from the guy who was sitting in his seat yesterday -- that you can blame the lack of hiring and capital investment on these budget deficits. That's ludicrous.

I mean, the idea that businesses are not investing in new plants or hiring people because they're worried about what the OMB says about long-term budget estimates I think belies the most obvious constraint that they're facing, and that is, very uncertain prospects for final demand, driven by an American consumer that's going to remain weak for years and years to come.

And we're not -- again, we're not going to change that overnight, given the de-leveraging and the saving that has to occur from our household sector. And I think -- and actually, I'm not blaming Jacob for saying it. He's just repeating what a former Federal Reserve chairman said. And you know, Jacob is a former central banker. And they have sort of like a club, you know. (Laughter.) They all agree with each other.

MALLABY: Well, as well as being allegedly ludicrous, he's being courteous, because he's passing me a note saying that if any of you seated around the side would like to sit down, there are actually two seats over here.

Do you feel the need to defend yourself?

FRENKEL: No, I was not attacked. (Laughter.)

ROACH: I'd never attack you.

FRENKEL: No, as you can see, Steve wanted to make sure that you are aware that he is a not a great admirer of the Fed. (Laughter.)

MALLABY: Okay.

FRENKEL: And he asks you to --

ROACH: I started my career there, Jacob.

FRENKEL: -- he asks you to forget the fact that he started his career there. (Laughter.)

MALLABY: Who's got another question? Let's go on the aisle towards the back.

QUESTIONER: To go back to the -- I'm Chen Weihua from China Daily. I just want to go back to the --

MALLABY: I'm sorry. We're supposed to be having questions from members first of all. So can you pass it just to the man in front of you?

QUESTIONER: Is this on? Okay. (Name and affiliation inaudible.) I want to go back to China also, but via The New York Times. Paul Krugman's piece earlier this week would, I think, be in some disharmony with what you were saying, because he basically says that Chinese fiscal policy is simply a tariff wall.

MALLABY: Is what?

QUESTIONER: That Chinese fiscal -- excuse me, not fiscal policy -- monetary policy is basically a tariff wall. And he says, tear down that wall.

MALLABY: Well, I mean, I think Steve has given his view on this. Steve basically said on this one that Chinese are stabilizing their fledgling financial system by having this anchored currency. That's their right. And people who get cross with that, it's sort of politics. And we shouldn't kid ourselves that, you know, we get out of a savings deficit in this country by beating up the Chinese.

Jacob, do you want to elaborate on that?

FRENKEL: Yes. I want to shift from the discussion of whether it is somebody's right or not to the economic issue involved. And we'll come to the same place at the end of the day.

At the present time, Chinese savings rate is extremely high. American savings rate is extremely low. This gap, unless this gap is changing -- and I'm leaving aside differences in investment propensities, because the savings differential is the thing that drives the gap -- with this in mind, it is not a puzzle that a country that saves a lot will export its goods abroad, if it is, because there is no domestic demand. And a country that consumes a lot more than it produces will import from the rest of the world. So that's an issue.

Well, why is it a problem if everyone is happy with all of that? The problem is that a very significant proportion of the U.S. Treasury bills that are held abroad are held in China. That will then become very vulnerable to changes in -- you don't want to be exposed to one banker. So there is all of those kind of concerns.

But at the end of the day, it will not be solved just by an exchange rate change unless you tell me that the exchange rate change will change this gap between savings in the two countries.

So it has also a prescription to policy. If you really want to have a constructive discussion with the Chinese about this gap, the way to go about it is to say, well, you Chinese are now saving quite a lot. In principle, it's your choice. But we recognize that one of the reasons why you save so much is that you have a rather underdeveloped social security system, an underdeveloped pension system. Many of the families are still having one child. You are having an aging population. So it stands to reason that there is an incentive for each family to self-insure and save a lot.

So how can we help you, we Americans? Let's design a program by which you will not need to save so much in order to secure your future. We will help you to develop your financial markets. And the beauty of financial markets that are well developed is that you can transfer purchasing power from the present to the future and from the future to the present in an easier way than otherwise.

So then we are translating and transforming the debate from an exchange-rate rivalry into a constructive, structural development that everyone is a win-win situation.

The answer always that I get for this is to say, yes, but that's never-never-land. Until we get the benefits -- let me tell you, if we started doing that at the time that we got off of those arguments that were allegedly explaining why we need to delay, we would have been there already.

So I think that --

MALLABY: I mean, but the counter argument is that, you know, this administration and the previous one had been having this kind of broad discussion about China's savings rate and how to change it for almost 10 years now.

ROACH: Yeah, but, Sebastian, wait a second. I mean, this -- Jacob's point is entirely right. And that is, is the bilateral exchange rate the mechanism to alter these savings imbalances. And he raises a serious question as to whether or not that presumption is correct. And I totally agree with it.

But you know, guess what? The Chinese get it. The Chinese know that their growth miracle for the last 30 years has been export led and also augmented by export-led investment. And in a post-crisis world, the external demand is not going to be there.

They need to continue rapid growth -- period. And so if they don't have the external support, they're going to turn internal. And I can promise you, Jacob, and you know this because we've spent a lot of time together in China, they are looking very, very hard at not just the social safety net, but at a lot of other measures that will stimulate internal private consumption.

I am prepared to say right here that they're going to raise their consumption share of GDP by at least five percentage points over this upcoming five-year planning period. They will draw down their national savings.

And by the way, that means they will have less surplus savings to send our way. And how the heck are we going to finance our budget deficit? So be careful what you wish for.

MALLABY: Okay. Next question. Let's go over there in the corner.

QUESTIONER: Steve Hellman (sp). Can I return to Europe for a quick second? Is the fundamental problem in Europe this dichotomy between fiscal policy being decided by the individual governments and the monetary policy being decided in Brussels? And is there any way to square that circle other than either devolving responsibility for monetary policy, again, back to separate currencies, or unifying fiscal policy?

FRENKEL: When the European dream was designed, everyone understood that if you give up your monetary policy instrument to the benefit of a unified ECB, the only way to make sure that the diversity is still consistent with each other is the risk convergence also in the other policy instruments. Otherwise, you will have a problem.

And indeed, they spent several years before they introduced the euro to develop a strategy that would have brought and indeed brought towards convergence. And when the convergence was in place -- deficit of no more than 3 percent of GDP, et cetera, the Maastricht Treaty, et cetera -- then the argument was, we are ready to get married.

But once they got married, they gave a party. And we spoke about it already earlier. So indeed, there is no way in which you can sustain completely different fiscal stand with the single monetary policy because, as we said, monetary policy is an aggregate policy that cannot be designed to say, today we need to have a contracturary for one part of the continent and then extensionary for another.

But that's the reality. They will not be willing to give up their political sovereignty. When they started to get married, to remind you, the debate was, the French saw that as the first step towards a much more coherent political unification. The Germans did not even want to think about it. The Brits stayed completely outside of it.

And sort of everyone said, okay, we all agree, the French and the Germans, that at least we can unify our monetary things. If it will be a temporary next step toward the next one or not, we will decide.

Lo and behold, shortly thereafter, the first two countries that broke the Maastricht Treaty were Germany and France. So there is an issue that reflects the political reality. And the euro system was designed by division of politicians, not by economists. Economists were very, very skeptical.

MALLABY: Let's see if we can get one last question. I see a hand over there on the side.

QUESTIONER: I think both of you agreed that this is dangerous without a credible exit strategy, fiscal and monetary. So what are your ideas for that, given 1937 and 1997 in Japan and the U.S. and the constraint that we need to continue to finance the deficit?

ROACH: Well, I'll start. I think the Federal Reserve in particular has to go through a, you know, a fairly logical process where, number one, it identifies what it thinks a normal interest rate should look like, a normal policy interest rate level should look like in this environment, whether that means the federal funds rate under, you know, a perfect economy should be four or two, leave that up to the Fed.

Number two, it needs to then lay out a fairly systematic trajectory by which, under the conditionality of their forecasts, today's zero interest rate would be allowed to converge on that normal interest rate target. And it needs to be very transparent in its policy statements to condition the markets to expect that over a certain period of time, rather than this sort of, you know, choosing words like "extended" or whatever in an effort to try to confuse markets and market participants.

And then number three, the Fed needs to be pragmatic in modifying that target in light of changing economic conditions. If the conditionality of the forecast turns out to be incorrect, then it needs to be very clear in telegraphing that. It's a methodical process, but I think it can be conducted, especially if it is judged against what I think should be the three objectives of monetary policy -- full employment, price stability and financial stability.

You might say, oh, that's a really hard thing to do. I think the Fed is perfectly capable of doing that as long as they can get away from this ideological mind-set that, you know, they should not even be talking about financial stability when they're setting their policy targets.

And you know, fiscal policy, I've already said my thing. But again, any short-term measures need to be accompanied by an explicit statement of what a long-term, more disciplined trajectory would look like.

MALLABY: Last word for you, Jacob.

FRENKEL: Well, I'm torn between picking up on that or spending the last 60 seconds on what you asked me to say, something about the regulatory reform.

So on that, I assume you are driving from time to time. Whenever I enter the highway, I really want to know, where is the exit? And if I'm not the only one in the car and I have somebody who navigates and holds the map, I want to make sure I share my thoughts with him or her. (Laughter.)

The second point concerning -- you asked me about the regulatory reform and the things that came out yesterday, the day before from Basel. I think that by and large, the main ingredients are very positive for the health of capital markets. We need to have a sound and safe financial system, which clearly the past several (excesses in ?) few years have demonstrated that one needs to have significantly more capital in the balance sheets of financial institutions, significantly more liquidity and significantly low leverage.

This goes without saying. And I think that many of the things are there.

The key issues, however, are where the devil is in some of the details. We need only to be aware that we will not have some unintended consequences. And let me just highlight one of them from the perspective of the U.S. system.

The global financial system is global. We want to make sure that the principles of playing a level field are maintained. So as we make our system sounder and safer, we want to make sure that we are not crowding ourselves out of the world financial competitive scene, because there is nothing more mobile than the operations of financial institutions.

And let me tell you that regulatory arbitrage is something that is being watched for time and again. So whereas in the past when one spoke about international policy coordination, harmonization, one spoke about the fiscal front, which was not a great success, today the effort should be to ensure that whatever is being done is done in harmony, harmony not in the sense that we will all feel good about it, but rather that we will not keep significant gaps in the regulatory theme, which, as it stands now, may work against the American financial institutions.

Another point which has not been discussed at all, but it has to do with it, is the fact of, it may be a bit technical, accounting standards. There are significant gaps between the accounting standards that are in one part of the globe and some other parts of the globe.

And again, when you want to have a globalized financial system, you want to make sure that there is much more coherence there. And the discussion in the past several years does not necessarily give me room for encouragement that something indeed is move concretely in this direction.

MALLABY: Okay. A plea for international collaboration, a good way to end a meeting at the Council on Foreign Relations.

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THIS IS A RUSH TRANSCRIPT.

SEBASTIAN MALLABY: Okay. I think we can get started. For those of you who don't know me, I am Sebastian Mallaby. I direct the Maurice R. Greenberg Center for Geoeconomic Studies here at the council. Thanks for coming to this latest meeting in the World Economic Update series.

Familiar housekeeping points first. This meeting is on the record. And please turn off those cell phones, things that go beep, vibrate, mess up the sound system, et cetera.

We've got two terrific speakers to get us up to date on what's going on. To my immediate left, Jacob Frenkel, chairman of JPMorgan Chase International, a long list of distinguished appointments before that. But I'll just pick out, two terms as governor of the Bank of Israel in the 1990s. Before that, sort of the chief economist role at the International Monetary Fund. And before that, on the economic faculty at Chicago.

And then over there is Steve Roach, non-executive chairman of Morgan Stanley -- (laughter) -- sorry, I'll be more precise in my language, in my gesticulations. So Steve Roach is chairman with Morgan Stanley international. Before spending, I guess, three years in Asia from 2007 to 2010, he was a longtime chief economist at the respected, kind of global (macroteam ?) at Morgan Stanley, and before that, a senior economist at the Federal Reserve Board in Washington.

So here we are. We want to update the world, at least its economy. It's not looking good. If you just look at the OECD forecasts, I think it adds, because it's a recent one, they have annualized growth in the third quarter that we're now in roughly at about half the rate that it was over the last quarter.

I was on a panel last night with Nouriel Roubini. You will not be surprised to hear that he thinks that the OECD forecast is way too optimistic. He thinks that, for example, the projected 2 percent in this quarter should be more in fact under 1 percent somewhere.

So Steve, let's not beat around the bush here. (Laughter.) Let's get to the obvious question. What the heck is going on? What -- (inaudible)?

STEPHEN S. ROACH: Did you say bush? (Laughter.)

MALLABY: I think that's your paranoia, not my linguistics. (Laughs.) Yeah, I think -- and so the question is, do we need more stimulus? I mean, monetary, fiscal, what mix? Or don't we need it?

ROACH: Well, Sebastian, the world is in trouble because the biggest economy in the world, the U.S., is dealing with the aftershocks of an era of extraordinary, reckless excess. And the biggest sector in the U.S. economy is the consumer. And the consumption share of U.S. GDP, close to 71 percent. It's still five points above the norm that prevailed in the final quarter of the 20th century when consumers were more rational, they spent out of income rather than borrowing against asset bubbles to draw down their savings rates to zero and take their debt loads up to records.

So we're in a period where that process is going to unwind now. And the consumption share of U.S. GDP is going to mean over the next several years, which means, you know, a percentage point reduction in the consumption share of U.S. GDP.

And stimulus, you know, if you do a classic Keynesian stimulus, you know, along the lines of the one that was enacted last year, it's not going to reverse that process. So I think we need to be wiser, prudent and more targeted in the way in which we try to provide stimulus, providing relief to the innocent victims of this recession, sluggish recovery and high unemployment.

We need targeted assistance to the long-term unemployed. We need a lot of retraining and re-skilling.

And then we need to focus on directing incentives for the types of activities that have always made America great. You know, on that basis, I applaud the initiative of the Obama administration to make the R&D tax credit permanent. But we need a lot more to stimulate the innovation in new technologies and new concepts.

And we just -- you know, believe me, I'm not a Tea Party person, but I can certainly understand the anger of a broad cross-section of Americans who just want to throw the rascals out, because they come up with the same, you know, tired, empty, vacuous rhetoric that got us into this mess in the first place.

So I think we have to be smart in the way we provide stimulus and not dogmatic, not idealogical. And you know, I think the role for monetary policy is very, very limited, despite what "Helicopter Ben" tells us.

And Jacob, of course, has done an awful lot of work on that over in his career, and probably has something to say on that as well.

MALLABY: Yeah, Jacob, I mean, I think it's right to say that in the late '80s at the International Monetary Fund, you were already talking about and analyzing the question of overburdened monetary policy. Are we back in the same world now where we're just asking too much of the central bank. And you ran one for 10 years. What's your view on that?

JACOB A. FRENKEL: Well, the answer is yes, but let me moderate it by following up on what Steve said. I felt to fully agree with you, but it has been a curse of us for the past few years that we agreed too much.

On the issue of stimulus, we need to find out why the stimulus package was less effective than what was hoped for. And unless we do that, doing more of the same is probably the wrong direction.

We had here yesterday a discussion in the morning, some of you may have heard it, speaking about the upset that a large deficit has on capital spending by corporations. So if you think that the estimate that we got yesterday was about 30 percent or 50 percent, that if you increase government budget deficit, that in and of itself will have an upset on the inclination of corporations to invest.

And one of the reasons is -- and that's part of the first answer -- when you see a large stimulus budget with a deficit and you don't see how you get out of it, obviously you are going to sit on your hands until the sun clears. So that's point number one.

It does not mean that there is no role for government. On the contrary, there is a significant role. But the role of government is not to compete with the private sector, but rather to facilitate the private sector. So we need to have a much longer-term perspective.

And most importantly, we need to understand how the sovereign debt crisis that has emerged all over the world is not going to plague us.

As far as overburdening monetary policy, there is an illusion that monetary policy, because it is a flexible policy instrument, and because it does not require Congress for an action, that's a good policy instrument to do Mickey Mouse policy up and down.

The reality is -- and I don't, by the way, refer to the current policy as Mickey Mouse. I'm talking about the inclinations of saying, well, here there is the policy instrument. You can do it, just get your act together. Sit down in a room, raise your hands, get a majority and move on. You don't need Congress.

And before long, you'll find that you have basically given a license to the true policy instrument that has to be implemented, the fiscal policy. You gave it a license to stay dormant, because some of the (others ?) will take the burden.

Let me make one more analogy, an analytical one and some material for thought. When you are a conductor of an orchestra and every musical instrument plays exactly according to the music that it has to play, you have harmony. And that's what people pay for.

Now, suppose now that one of the important policy instruments is playing off tune. As a conductor, what should you do? Your first inclination is to bang on him and say, why won't you get back to the harmony while the rest of us musical instruments play the right music? But if you give up and you basically say, okay, I know that you cannot do that, or you tell me that you cannot do that, what would you do as a conductor? Would you continue with a cacophony where the rest of the policy instruments do allegedly what they were supposed to do, but it doesn't match what he is doing, the major instrument? Or would you change now the music that the others will need to play so as to bring to a distorted harmony consistent with the off-tune playing of the major instrument?

It's a major question. Because in the short run, the inclination is to say, well, save the day, the other guy is not playing, jump into the vacuum. And this was the logic of the ECD, jumping when the fiscal authorities did not do things. This is the logic in this country where monetary policy is doing much more.

And I'm not saying that it should not be done in the short run. But there is always the tendency that you get into bad habits. We have here the tradition that monetary policymakers do not discuss publicly the fiscal policy standing. But we all know that's the true gorilla in the room. And without the fiscal policy discussion, putting up front a strategy for exit, we are playing the wrong game by discussing again and again the policy instruments that are practically exhausted.

MALLABY: But if we take sort of concretely, what is the danger? Excess monetary policy, excess stimulus from the monetary side, is the problem that it's sort of potentially pumping up demand, getting us back to somewhere nearer to what the economy's growth potential is, but at the cost of distorting the structure of the economy, because the interest-rate-sensitive chunks will grow first, you will get more boom in real estate and again?

ROACH: No, Sebastian. I mean, this is the same argument that we had after the bursting of the equity bubble in 2001 and 2002, although it's amplified because the degree of the stress is so much more acute.

And in the aftermath of that earlier post-bubble period, we had a central bank that embraced a period of extended, excessive monetary accommodation and stayed easy for far too long, despite the protests of the former chairman of the institution, who was, I believe, sitting on this stage yesterday, and his successor, both of whom strenuously argue that monetary policy had nothing to do or very little to do, they might concede in their darkest moments, with the subsequent bubbles that occurred in property and credit.

I personally think that's ludicrous. And by going back to the same script that recreated the monster bubbles, we have a central bank that is ignoring the role of liquidity and leverage and asset bubbles, and distorting the real side of the U.S. economy. And I don't think that we should condone that type of behavior again.

I'm jumping ahead, but I think -- and I know you want to get to the, you know, the Frank-Dodd regulatory initiative as well as Basel III. But you know, I think the regulatory fix is necessary, but not sufficient to avoid these problems in the future. If you don't address the serious flaws of monetary policy, we're going to have this mess again. You're entirely right.

FRENKEL: Well, the issue of bubbles has been with us for many, many years. And there was always the question of, should monetary policy burst the bubble before the bubble bursts?

And the general debate has been on the question of, does the monetary authority have an informational advantage that the private sector does not have? And if yes, then it should act upon it. If not, then it's a different matter.

In the old days, the objective of monetary policy was price stability. As we move on, the objective now all over the world is price stability and financial stability. And of course, bubbles that (are ?) -- go out of control do impact significantly financial stability, because when they burst, they upset balance sheets of everyone, including financial institutions, and create a lot of further pro-cyclical developments that are not desirable.

However, we need to draw a distinction between two types of bubbles. Bubbles that arise from debt finance or bank finance growth, if they arise from that, then to mop up the mess in the aftermath is rather complicated. And when it comes to bank finance and debt finance, the central bank may have actually an informational advantage.

On the other hand, bubbles of the type of, say, the dot-com that reflected more equity finance, well, there is no presumption that the central bank has an informational advantage or therefore that it should really be actively playing around with it.

So the issue is more subtle than what --

MALLABY: So in other words, your view is that the Fed, after the dot-com, sort of learned a generalized lesson about how to treat bubbles by cleaning up afterwards. And you're saying, no, there's two different kinds of bubbles. If it's a bank-fueled, credit-fueled bubble, that's different.

FRENKEL: Because the logic is not whether bubbles are good or bad, but rather, does the monetary authority have the information and advantage?

There is one important distinction between monetary policy in general and fiscal policy. Monetary policy is an aggregated policy. It affects the aggregate of the economy. Of course, some sectors are more sensitive to interest rates than others. But when you have a monetary policy, it affects everything.

Fiscal policy is designed to be a sector of policy. So there is a sectoral issue. That's why you have tax instruments and the like. And we should really not confuse between the two.

ROACH: But let me just go back to a point you made earlier, Jacob, where you said that, you know, in the old days, it was price stability, and now it's price stability and financial stability.

You and I are both old enough to remember before the old day.

FRENKEL: Older day. (Laughs.)

ROACH: In 1946, the Employment Act was passed by the U.S. Congress that mandated the central bank solely to focus on full employment, legacy of the Great Depression. It worked great for 30 years, then the Fed blew it, double-digit inflation. Humphrey-Hawkins legislation passed in 1978, which then added price stability to the explicit mandate. I would argue that the Fed has blown it again.

So you say that, well, everybody now focuses on financial stability. I don't trust the central banks to say, oh, don't worry, we've learned our lesson. I want that hardwired into the mandate. I want the Fed and other major central banks to issue a financial stability report every, you know, six months or 12 months. I want them to set not just the federal funds rate, but other types of policy instruments, whether there are margin requirements on equities or down payments on property, like the Chinese are doing right now, to utilize the full range of their authority to prevent these bubbles from infecting the economy.

And finally, I would just say, you're entirely right in saying that monetary policy is a blunt instrument. We needed a blunt instrument to deal with these problems.

At their worst in the 2005 to 2007 period, the bubbles in property and credit distorted consumption and home-building activity, which were collectively 77 percent of the U.S. GDP. That's what you have a blunt instrument for. The whole economy was distorted --

MALLABY: But I think Jacob is agreeing with that, right? And he's saying --

ROACH: Yeah.

MALLABY: -- when you have a credit bubble like that, you should act.

FRENKEL: But his voice is intending to create an atmosphere for debate. (Laughter.)

ROACH: Yeah!

MALLABY: Let me put something else on the table.

ROACH: It's my genetic predisposition.

MALLABY: Let me put something else on the table, which we've been talking about, but, Jacob, I want to put this a bit more directly.

So we've been talking about the way there is potentially a trade-off between short-term return to growth and whether it's long-term sustainable. And in some ways, stimulating too much now could make it less sustainable, right?

But there is one dimension on which early stimulus could actually raise the longer-term trend potential, and that is through the labor market. I mean, if you let people stay out of work for an extended period, we all know they de-skill, they drop out of the labor force, and, effectively, you've lost productive labor, you've lost skilled labor. So that's an argument, isn't it?

In other words, if you just take the whole picture in terms of this long-term/short-term trade-off, some of these arguments point in the direction that long term gets you more short-term growth -- I mean, short term gets you more long term, and others don't.

So where do you come out on that?

FRENKEL: Well, two points. First, you are perfectly right that when you ask, what's the rate of unemployment in an economy, that's not good enough of a statistic. You need to ask, what's the unemployment rate of the economy? And what's the average length of the unemployed cohort in the unemployment group?

Because we all know, and that's universally established, that the longer one is unemployed, the more likely it is that he will not regain employment. He may actually leave the labor force. So the length of time is important.

And in this regard, we should not allow things to get out of hand, so to speak.

But the solution for long-term issues, the solution does not come from shorter measures. If you ask, what's the unemployment rate among well-educated, high-skilled individuals? There, the unemployment rate is very, very low. It so happens that most of those who have been employed in the consumption industry are also low-skilled individuals or lower education.

So the long-term solution is an educational system and retraining system and the like. And then you come and say, yes, but how will I make it to the long run? I need to survive. Let's do some short-run policies. And that's where your question is so pertinent.

I don't -- I'm not -- I'm not too excited from the sharp distinction between short term and long term. If you don't do the right long-term policies, your short-term measures will be less effective than what they would have been if it was in an environment in which there are long-term sustainable policies.

The essence of capital markets is exactly designed to blur the distinguishing between long run and short run, because if you all expect something to happen in the long run, the beauty of capital markets is that it brings it back to the future.

The nonsustainability of short-term measures that can be measured only by the long-run consequences immediately impact adversely on the effectiveness in the short term.

So I would not really have a department dealing with, you do the short run and the other one does the long run. In the old days, there was such a distinction. For example, the IMF was supposed to deal with short run, the World Bank, long run. It just does not work. There is no way to go to the one without having the right policy on the other.

MALLABY: Steve, a question on China. You know, this week, I think today, actually, Tim Geithner is in Congress testifying about what he thinks on the Chinese exchange rate. It is a bit of a mystery, isn't it, that they announced, the Chinese, an apparent policy shift on the exchange rate, and then basically didn't deliver. And in the meantime, they have succeeded in annoying not only the U.S. Congress, which is a pretty low threshold -- (laughter) -- but they've got the Japanese intervening in their currency markets in response, and now the Europeans are angry that the Japanese have done it unilaterally.

They've potentially set up a sort of chain reaction here. Why not just move a little bit?

ROACH: Well, first of all, Sebastian, when the Chinese announced that their sort of temporary crisis-driven suspension of their managed float was over last July, they didn't lay out a trajectory of the renminbi cross rate. They simply said that, you know, we're going back to a more flexible policy.

And they have a policy that gives them the leeway to vary the renminbi And they have elected in a still extremely fragile global climate to be very cautious and judicious in the way in which they let their currency fluctuate. You know, the political protagonists of course refer to this manipulation. And the Chinese and others, including myself, refer to this as a focus on a stability anchor for an embryonic financial system.

And given what's gone on in world financial markets in recent years, having a stability anchor and policies that are aimed at that is not a particularly bad thing.

But obviously, this is a political year. And Tim Geithner is, I think, very mindful of not just the politics, but the complexities of dealing with bilateral cross rates in a multilateral world. And he actually, I think, did a fairly effective job in addressing that issue last spring and was hopeful that the Chinese would give him some cover.

That has not turned out to be the case. And now with the election season at hand and the drumbeat in the Congress getting louder and the Obama administration, and the Democratic Party in general, in serious trouble, then the rhetoric gets dominated more by politics than by a global macro.

But you know, the point to make in the United States is another dimension of this very painful reality. And that is that if we think for a moment we're going to solve our problems by bashing the Chinese, we are diluting ourselves.

Our main problem is the lack of national savings, an overall national savings rate adjusted for depreciation that is now negative to the tune of, you know, minus 2.5 percent of GDP. So we need to import surplus savings from abroad in order to grow, and then we have to run these massive current account and multilateral trade deficits to attract the capital.

Last year, we ran bilateral trade deficits with 90 -- that's nine, zero -- countries, including the Chinese. So if we pass a currency bill and don't save, which we're not going to do, and say, shut down the Chinese, the Chinese piece of our multilateral imbalance goes somewhere else to a higher-cost producer which taxes the American public.

But you know, the Congress is clueless in understanding this. I've testified repeatedly on this subject. And I gave up and moved to Asia. (Laughter.)

MALLABY: I want to bring in the audience in a second. But Jacob, maybe you could just comment briefly on Europe. You know, we've had a trillion-dollar bailout for Greece, roughly, and spreads seem to be back up to almost where they were. Why do the markets remain so skeptical about --

FRENKEL: Well, to begin with, it used to be called the problem of Greece. With the passage of time, it became clear that Greece is not the name of a country, it's the name of a phenomenon, a phenomenon that is shared by other countries -- Ireland, Portugal and the like.

And the phenomenon is a phenomenon of significant sovereign without a mechanism that convinces the market that that sovereign debt can be paid in the right way.

And indeed, if you ask yourself, what happened during the decade or so, a little more, since the introduction of the euro, there was no issue of imbalances or things of that type within Europe at that stage. And then a decade passed. And how did the various countries respond? Greece, Ireland, Portugal decided to give a party and to increase their consumption and spending to an extraordinary degree, cut down their savings by about 12 percentage points, or 14, depending on which country.

And of course, if you do it, you have to borrow and incur debt. And in Greek situation, the debt was foreign debt.

On the other side of the very same euro, you had Germany which decided to raise its savings rate. So lo and behold, Germany has been running surpluses in the current account; the rest of the eurozone countries, the problem countries, big deficits.

So this party had to get to an end. When the rest of the world, namely the Europeans, had decided to put on the line commitments of up to $1 trillion, everyone, the ECB, the European community, IMF, the idea was, we will put enough money so as to convince the market that in the coming two, three years, even if all of these countries did not have access to the capital market, they have enough resources to service the debt. And therefore, you, capital market guys, don't worry, there can be no default, there is enough money.

Where was the skepticism? The skepticism comes from two dimensions. Dimension number one is the short term, because everything was dependent upon a very significant structure adjustment in many of these countries that have lost competitiveness. And the question that markets had was, will the political process sustain such a dramatic change? And if not, then it doesn't help that there is enough money there, because the money is conditional on policy.

But the second and most fundamental one is the question of, what will happen after two, three years when there is no additional aid? Will these countries create the infrastructure that will sustain growth without external help so that they can go to the capital markets? And here there are significant doubts.

Same question that we had on the first issue of the stimulus in this country. We now see that, as the effect of the various stimulus measures are withdrawn, the question has been, will there be enough momentum? Or are we going to do need to do something else?

So that's the reason why the markets are very, very nervous. And it is again the issue of capital markets. The capital markets do not tolerate the distinctions between long run and short run. They will show you in the short run (or in the middle ?) exactly what they believe will happen in the long run. And it doesn't help that you have something for the next two years.

ROACH: But Jacob, just to follow up on that, I mean, aren't you surprised at how low long-term sovereign bond yields are in the context of what you just said?

FRENKEL: Well, the reality is that Greece has now spreads over Germany of about, how much? Nine hundred basis points?

ROACH: Yeah, the spreads are wide. But what about, you know, the benchmarks --

FRENKEL: The level itself.

ROACH: -- (less free ?) in the levels.

FRENKEL: Yes, that's correct. Yeah. Our paradigm is challenged here. We all would have thought that by now long-term interest rates will be higher than what they are. And potentially, even inflationary pressures would have been higher than what they are.

But I would not give a party today. (Laughter.)

MALLABY: Okay. Well, with that, let's have a party here. And who's got questions from the members in the audience?

Let's go right here to begin with. Please state your name and affiliation.

QUESTIONER: Niso Abuaf, Pace University. I would like to hear the panel's thoughts on the deflation versus inflation debate. And associated, why the rewrites of interest in the TIPS market are so low. Thanks.

MALLABY: That's a good segue from where we were before.

ROACH: Well, I think over the reasonably foreseeable future, the risks still are skewed more toward deflation than inflation. There's just enormous slack in the global economy. I don't look for a sharp precipitous deflation. It would be more of a, you know, a periodic dip from time to time, depending upon the state of the global economy.

I think the inflation issues are fairly distant. And I think the bond market is generally consistent with that. They will arise if, at some point in time, it looks like it's evident that we're starting to absorb the slack capacity in the global economy and we don't have credible exit strategies for the fiscal and monetary authorities.

And then I think there is a legitimate case to be worried about that. What the authorities are telling you is, you know, trust us, we know what we're doing, and we have time to develop coherent exit strategies.

The history of the last 20 years suggests that one should be rather dubious of trusting our wise public authorities in that regard.

FRENKEL: Well, I'll make two points about it. First, you spoke about the last 20 years. I want to take you to the last 80, 90 years. When you are looking around the world and ask, why is it the case that in Germany there is greater concern about inflation than in some other places in the world, the answer is their legacy from the hyperinflation of the '20s. Practically, there are very few individuals that are alive that have actually experienced that one, but it is becoming part of the DNA.

When in the U.S., some years ago, there was the popular view that our main danger today is deflation, I can tell you that in some countries of the world, especially in Latin America -- and I can tell you also, where I came from, from Israel -- there were some eyebrows raised by saying, well, you are spoiled, you did not experience the inflation as these countries have, and therefore don't be excessively sanguine about it. It does not mean that you need to be (paranoic ?) about inflation. And I agree with Steve's assessment that today there are really basically no inflationary pressures anywhere in the pipeline. That's not the issue.

The issue is, as a strategy, do you want to design a policy which is asymmetric, namely be more nervous from the deflation than from the inflation as a central bank, not as a conductor of the orchestra? Or do you want it to be symmetric?

In Europe, it is symmetric. In most countries of the world, it is symmetric because of the legacy. In this country, it is now somewhat designed to be asymmetric. And that's an open issue, especially when one recognizes that markets do not always recognize political boulders.

So what is true in one part of the world and is not always true in another part of the world needs to be reconciled.

MALLABY: Okay, let's go over here. Wait for the microphone.

QUESTIONER: (Off mike.)

MALLABY: Microphone.

QUESTIONER: Excuse me. Steve Robert. Both Chairman Greenspan, who was here yesterday, and both of you, I think, are warning us of the dangers of the government deficit and particularly as it relates to a chewing up of savings and lack of capital investment by the corporate sector.

So that seems to go in the direction of removing stimulus faster and solving the deficit problem faster. That's certainly what Chairman Greenspan said yesterday.

On the other hand, there's a whole other group of economists who have the opposite view. And they tend to cite very often 1937 where the government tried to retract stimulus and come closer to balancing the budget. And the general feeling is that exacerbated the depressionary environment we were in.

And then they come to something more recent, which is the Japanese experience over the last 15 years. And it appears that each time they move toward fiscal restraint, their slow economy or recession got worse and worse.

So are we in a period more like 1937 or Japan in the last 15 years, where it might be very dangerous to try to deal with the deficit too fast?

FRENKEL: I think that this is probably the most central issue today in the policy arena. And in order to respond to it properly, since both considerations are correct, if you withdraw it now, you aggravate a recession, if you accelerate it now, you aggravate the debt problem. And you need to basically be a bit more refined, and the refinement has to do with two dimensions. First, the composition; and second, the timing.

Composition -- one of the reasons why, as Steve said at the very beginning, a part of the stimulus package was less stimulating than what it was intended to be, was that it did not really enhance sufficiently the infrastructure that would promote growth once it is withdrawn. Spending were in the directions, at the end of the day, were more improving the standard of living of some very important segments and things of that type rather than focusing specifically on, what will maximize growth prospects once it is withdrawn? So the composition is an area.

Unfortunately, the location of government budgets are determined, among others, by political considerations. And the things that are enhancing growth do not have a strong political logic because the beneficiary is not identified immediately in the same moment.

The second point has to do with the timing. We should not ask only, what do we do in 2010 and 2011, because this really is too constraining. I repeat what I said before. The same stimulus budget that will take place in 211, along with a very explicit discussion and presentation about what will happen in 213, '14 and what's the mechanism to close the deal, will be very much more effective than if it is an open-ended one.

Because time and again, when you talk to the corporate sector, they will tell you, I am reluctant to move because of the uncertainty that I am there. The government need not add to the uncertainty, but rather to reduce it. And that's really one of the important points.

ROACH: I agree, this is a critical issue. And thank you for raising it. There's a lot of fear mongering going on ala hearkening back to the mistakes that were made in 1937. And out of that fear mongering comes the belief that you shouldn't dare discuss the restoration of normal fiscal or monetary policies in this environment.

And I think that that's really ideologically far too extreme for me. I'm not arguing that we should move aggressively to fiscal or monetary normalcy to date, but we do need to have, as Jacob just said, a reasoned discussion about how we are going to find a way out when, you know, we're through the worst of the situation.

And I think it's very important for us, if we're considering additional stimulus actions to deal with the victims of long-term unemployment or to put in place incentives for research, development and innovation, that any additional stimulus must be accompanied by a much more explicit definition of what an exit strategy will look like.

It is reckless to just go to the American people and say, you know, here's another few hundred billion and, you know, we'll deal with it later. The reason we won't deal with it later, because if I'm right, and the second part of your question plays to something I'm very sympathetic to, is that we are in a slow-growth Japanese-like scenario that will not generate enough growth to produce the normal windfall of revenues that will self-correct the budget deficits that we've built today.

We're going to be stuck with a legacy of federal debt, as the Japanese are right now with their debt-to-GDP ratio of 200 percent.

MALLABY: Great, but if --

ROACH: Let me just say one last thing, because I do want to find one point to disagree with Jacob on -- (laughter) -- and that is, this ridiculous notion -- and this is not -- and Jacob is borrowing it from the guy who was sitting in his seat yesterday -- that you can blame the lack of hiring and capital investment on these budget deficits. That's ludicrous.

I mean, the idea that businesses are not investing in new plants or hiring people because they're worried about what the OMB says about long-term budget estimates I think belies the most obvious constraint that they're facing, and that is, very uncertain prospects for final demand, driven by an American consumer that's going to remain weak for years and years to come.

And we're not -- again, we're not going to change that overnight, given the de-leveraging and the saving that has to occur from our household sector. And I think -- and actually, I'm not blaming Jacob for saying it. He's just repeating what a former Federal Reserve chairman said. And you know, Jacob is a former central banker. And they have sort of like a club, you know. (Laughter.) They all agree with each other.

MALLABY: Well, as well as being allegedly ludicrous, he's being courteous, because he's passing me a note saying that if any of you seated around the side would like to sit down, there are actually two seats over here.

Do you feel the need to defend yourself?

FRENKEL: No, I was not attacked. (Laughter.)

ROACH: I'd never attack you.

FRENKEL: No, as you can see, Steve wanted to make sure that you are aware that he is a not a great admirer of the Fed. (Laughter.)

MALLABY: Okay.

FRENKEL: And he asks you to --

ROACH: I started my career there, Jacob.

FRENKEL: -- he asks you to forget the fact that he started his career there. (Laughter.)

MALLABY: Who's got another question? Let's go on the aisle towards the back.

QUESTIONER: To go back to the -- I'm Chen Weihua from China Daily. I just want to go back to the --

MALLABY: I'm sorry. We're supposed to be having questions from members first of all. So can you pass it just to the man in front of you?

QUESTIONER: Is this on? Okay. (Name and affiliation inaudible.) I want to go back to China also, but via The New York Times. Paul Krugman's piece earlier this week would, I think, be in some disharmony with what you were saying, because he basically says that Chinese fiscal policy is simply a tariff wall.

MALLABY: Is what?

QUESTIONER: That Chinese fiscal -- excuse me, not fiscal policy -- monetary policy is basically a tariff wall. And he says, tear down that wall.

MALLABY: Well, I mean, I think Steve has given his view on this. Steve basically said on this one that Chinese are stabilizing their fledgling financial system by having this anchored currency. That's their right. And people who get cross with that, it's sort of politics. And we shouldn't kid ourselves that, you know, we get out of a savings deficit in this country by beating up the Chinese.

Jacob, do you want to elaborate on that?

FRENKEL: Yes. I want to shift from the discussion of whether it is somebody's right or not to the economic issue involved. And we'll come to the same place at the end of the day.

At the present time, Chinese savings rate is extremely high. American savings rate is extremely low. This gap, unless this gap is changing -- and I'm leaving aside differences in investment propensities, because the savings differential is the thing that drives the gap -- with this in mind, it is not a puzzle that a country that saves a lot will export its goods abroad, if it is, because there is no domestic demand. And a country that consumes a lot more than it produces will import from the rest of the world. So that's an issue.

Well, why is it a problem if everyone is happy with all of that? The problem is that a very significant proportion of the U.S. Treasury bills that are held abroad are held in China. That will then become very vulnerable to changes in -- you don't want to be exposed to one banker. So there is all of those kind of concerns.

But at the end of the day, it will not be solved just by an exchange rate change unless you tell me that the exchange rate change will change this gap between savings in the two countries.

So it has also a prescription to policy. If you really want to have a constructive discussion with the Chinese about this gap, the way to go about it is to say, well, you Chinese are now saving quite a lot. In principle, it's your choice. But we recognize that one of the reasons why you save so much is that you have a rather underdeveloped social security system, an underdeveloped pension system. Many of the families are still having one child. You are having an aging population. So it stands to reason that there is an incentive for each family to self-insure and save a lot.

So how can we help you, we Americans? Let's design a program by which you will not need to save so much in order to secure your future. We will help you to develop your financial markets. And the beauty of financial markets that are well developed is that you can transfer purchasing power from the present to the future and from the future to the present in an easier way than otherwise.

So then we are translating and transforming the debate from an exchange-rate rivalry into a constructive, structural development that everyone is a win-win situation.

The answer always that I get for this is to say, yes, but that's never-never-land. Until we get the benefits -- let me tell you, if we started doing that at the time that we got off of those arguments that were allegedly explaining why we need to delay, we would have been there already.

So I think that --

MALLABY: I mean, but the counter argument is that, you know, this administration and the previous one had been having this kind of broad discussion about China's savings rate and how to change it for almost 10 years now.

ROACH: Yeah, but, Sebastian, wait a second. I mean, this -- Jacob's point is entirely right. And that is, is the bilateral exchange rate the mechanism to alter these savings imbalances. And he raises a serious question as to whether or not that presumption is correct. And I totally agree with it.

But you know, guess what? The Chinese get it. The Chinese know that their growth miracle for the last 30 years has been export led and also augmented by export-led investment. And in a post-crisis world, the external demand is not going to be there.

They need to continue rapid growth -- period. And so if they don't have the external support, they're going to turn internal. And I can promise you, Jacob, and you know this because we've spent a lot of time together in China, they are looking very, very hard at not just the social safety net, but at a lot of other measures that will stimulate internal private consumption.

I am prepared to say right here that they're going to raise their consumption share of GDP by at least five percentage points over this upcoming five-year planning period. They will draw down their national savings.

And by the way, that means they will have less surplus savings to send our way. And how the heck are we going to finance our budget deficit? So be careful what you wish for.

MALLABY: Okay. Next question. Let's go over there in the corner.

QUESTIONER: Steve Hellman (sp). Can I return to Europe for a quick second? Is the fundamental problem in Europe this dichotomy between fiscal policy being decided by the individual governments and the monetary policy being decided in Brussels? And is there any way to square that circle other than either devolving responsibility for monetary policy, again, back to separate currencies, or unifying fiscal policy?

FRENKEL: When the European dream was designed, everyone understood that if you give up your monetary policy instrument to the benefit of a unified ECB, the only way to make sure that the diversity is still consistent with each other is the risk convergence also in the other policy instruments. Otherwise, you will have a problem.

And indeed, they spent several years before they introduced the euro to develop a strategy that would have brought and indeed brought towards convergence. And when the convergence was in place -- deficit of no more than 3 percent of GDP, et cetera, the Maastricht Treaty, et cetera -- then the argument was, we are ready to get married.

But once they got married, they gave a party. And we spoke about it already earlier. So indeed, there is no way in which you can sustain completely different fiscal stand with the single monetary policy because, as we said, monetary policy is an aggregate policy that cannot be designed to say, today we need to have a contracturary for one part of the continent and then extensionary for another.

But that's the reality. They will not be willing to give up their political sovereignty. When they started to get married, to remind you, the debate was, the French saw that as the first step towards a much more coherent political unification. The Germans did not even want to think about it. The Brits stayed completely outside of it.

And sort of everyone said, okay, we all agree, the French and the Germans, that at least we can unify our monetary things. If it will be a temporary next step toward the next one or not, we will decide.

Lo and behold, shortly thereafter, the first two countries that broke the Maastricht Treaty were Germany and France. So there is an issue that reflects the political reality. And the euro system was designed by division of politicians, not by economists. Economists were very, very skeptical.

MALLABY: Let's see if we can get one last question. I see a hand over there on the side.

QUESTIONER: I think both of you agreed that this is dangerous without a credible exit strategy, fiscal and monetary. So what are your ideas for that, given 1937 and 1997 in Japan and the U.S. and the constraint that we need to continue to finance the deficit?

ROACH: Well, I'll start. I think the Federal Reserve in particular has to go through a, you know, a fairly logical process where, number one, it identifies what it thinks a normal interest rate should look like, a normal policy interest rate level should look like in this environment, whether that means the federal funds rate under, you know, a perfect economy should be four or two, leave that up to the Fed.

Number two, it needs to then lay out a fairly systematic trajectory by which, under the conditionality of their forecasts, today's zero interest rate would be allowed to converge on that normal interest rate target. And it needs to be very transparent in its policy statements to condition the markets to expect that over a certain period of time, rather than this sort of, you know, choosing words like "extended" or whatever in an effort to try to confuse markets and market participants.

And then number three, the Fed needs to be pragmatic in modifying that target in light of changing economic conditions. If the conditionality of the forecast turns out to be incorrect, then it needs to be very clear in telegraphing that. It's a methodical process, but I think it can be conducted, especially if it is judged against what I think should be the three objectives of monetary policy -- full employment, price stability and financial stability.

You might say, oh, that's a really hard thing to do. I think the Fed is perfectly capable of doing that as long as they can get away from this ideological mind-set that, you know, they should not even be talking about financial stability when they're setting their policy targets.

And you know, fiscal policy, I've already said my thing. But again, any short-term measures need to be accompanied by an explicit statement of what a long-term, more disciplined trajectory would look like.

MALLABY: Last word for you, Jacob.

FRENKEL: Well, I'm torn between picking up on that or spending the last 60 seconds on what you asked me to say, something about the regulatory reform.

So on that, I assume you are driving from time to time. Whenever I enter the highway, I really want to know, where is the exit? And if I'm not the only one in the car and I have somebody who navigates and holds the map, I want to make sure I share my thoughts with him or her. (Laughter.)

The second point concerning -- you asked me about the regulatory reform and the things that came out yesterday, the day before from Basel. I think that by and large, the main ingredients are very positive for the health of capital markets. We need to have a sound and safe financial system, which clearly the past several (excesses in ?) few years have demonstrated that one needs to have significantly more capital in the balance sheets of financial institutions, significantly more liquidity and significantly low leverage.

This goes without saying. And I think that many of the things are there.

The key issues, however, are where the devil is in some of the details. We need only to be aware that we will not have some unintended consequences. And let me just highlight one of them from the perspective of the U.S. system.

The global financial system is global. We want to make sure that the principles of playing a level field are maintained. So as we make our system sounder and safer, we want to make sure that we are not crowding ourselves out of the world financial competitive scene, because there is nothing more mobile than the operations of financial institutions.

And let me tell you that regulatory arbitrage is something that is being watched for time and again. So whereas in the past when one spoke about international policy coordination, harmonization, one spoke about the fiscal front, which was not a great success, today the effort should be to ensure that whatever is being done is done in harmony, harmony not in the sense that we will all feel good about it, but rather that we will not keep significant gaps in the regulatory theme, which, as it stands now, may work against the American financial institutions.

Another point which has not been discussed at all, but it has to do with it, is the fact of, it may be a bit technical, accounting standards. There are significant gaps between the accounting standards that are in one part of the globe and some other parts of the globe.

And again, when you want to have a globalized financial system, you want to make sure that there is much more coherence there. And the discussion in the past several years does not necessarily give me room for encouragement that something indeed is move concretely in this direction.

MALLABY: Okay. A plea for international collaboration, a good way to end a meeting at the Council on Foreign Relations.

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The normal rhythm of politics tends to lead most nations’ economies around in a circle, ashes to ashes. This life cycle starts with a crisis, which forces leaders to reform, which triggers an economic revival, which lulls leaders into complacency, which plunges the economy back into crisis again.

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